Crouching Fraud, Hidden Losses

Beginning Jan. 1, China’s companies have been booking their profits under a new accounting regime, based on international accounting standards. It’s estimated some 20,000 staffers from U.S. accounting firms are there, boots on the ground, helping China’s companies scrub their books to bring them up to speed.

But what does this mean for investors, and what can they expect to see?

In an admission rare for China’s historically tight-lipped bureaucrats, Zheng Shaodong, assistant minister of public security, told the government press that China does not have sufficient resources to deal with the mounting number of economic crimes. “Many economic crimes are either not detected or unable to be investigated, and this represents a threat to social harmony,” he said.

Fraud reaches into the lifeblood of China’s economy, its state-run banking sector. The China Banking Regulatory Commission said in 2005 that it had punished 799 staff members of the country’s four biggest state banks after finding they were involved in illegal or unauthorized loans totaling $73 billion, according to government reports.

Another trouble spot is that financial disclosures are so poor, investors can never see trouble coming. And China still puts a stranglehold on post-mortem details about these flame-outs, leaving investors in the dark.

When Euro-Asia Agricultural, a Chinese orchid business, went belly up in 2004, the government would only disclose in official press reports that the company had inflated its revenues. It’s still unclear how exactly the company padded its revenues, since China’s financial authorities have not released further details.

Similarly, within months of China Life Insurance’s huge $3.5 billion initial public offering in 2004, state auditors found $652 million worth of irregularities, according to official press reports. Government auditors will only say the irregularities involved “inappropriate competitive problems” and “inappropriate” use of premium funds, including loans and investments. It also found that millions of yuan had been placed into “little treasuries,” which are off-book accounts used to distribute bonuses…

Moreover, loopholes are already being written into the new disclosure statutes. China’s state-owned companies have been exempted from having to disclose related-party deals, endemic in China. Related-party deals usually equate to shareholder capital wasted on insider cronyism for such items as company loans, real estate or consulting deals.

Donald Straszheim, former chief economist at Merrill Lynch and now vice chairman of Roth Capital Partners, recently noted in a report that investors will be effectively shipping money to China’s government without any disclosure on the deals. That might be reason enough to stay away. Both Shanghai and Shenzhen “were launched 15 years ago not as a place where sources of capital and uses of capital could meet, but rather as a way for the state to attract outside investors, thereby increasing the value of the existing government stake in those companies,” Straszheim says. Besides related-party deals, Chinese corporations are still struggling to account for basic line items. “In terms of profits, returns and other indicators, 70% of listed companies on the mainland do not meet international standards,” Cheng Siwei, vice-chairman of the National People’s Congress, warned investors at a Financial Times China-Middle East summit in Dubai earlier this year.

China’s “socialism with Chinese characteristics” has fared well over the past 29 years, but what will become of China’s predominantly state-led capitalism in the years to come without inspired investor confidence in the accounting profession?